Corporate Governance and Finance:

Investor Protection and Company Ownership

Nino PapiashviliInstitute of Finance

Ulm University

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Introduction

Securities are identified by:

1. Their cash flows (dividends vs. fixed payments)

2. Rights to their owners (control rights: rights to vote and rights to collateral)

The rights give investors the power to extract from managers the returns on their investments. Otherwise if there is no control there is no payment and it gets hard for the firms to raise external finance

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Topic of the Presentation

• Does being a shareholder in one country give the same rights to investors as in another?

• Would a creditor in one state fear the same when the borrower defaults as in another?

=>General rights of the claimants depend on legal rules of the jurisdictions in which securities are issued.

The protection investors receive determines their readiness to finance firms –which helps to explain why firms are financed and owned differently in different countries: Why Italian companies rarely go public; Why does Germany have such a small stock market but maintain large and powerful banks; Why is ownership of large American and British companies so widely dispersed etc.

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Countries’ Legal Origins

Two broad legal traditions where commercial laws come from:

1. Common Law (English Law) – formed by judges, based on precedents from judicial decisions. Practiced in - Britain and British colonies: USA, Canada, Australia, India etc.

2. Civil Law (Roman Law) - uses statutes and comprehensive codes and consists of three major families:

French Civil Law – Belgium, Netherlands, France, Italy, Luxembourg, Portugal, Spain. Also French, former Spanish and Portuguese colonies.

German Civil Law - Germany, Austria, Switzerland, Japan, South Korea (among others)

Scandinavian Civil Law – Denmark, Finland, Norway, Sweden

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Legal Protection of Investors

Legal Rules that are being examined refer to:

Rights of investors: voting powers, ease of participation in corporate voting, legal protections against expropriation by management

Rights of Creditors: security of the loan, ability to grab assets in defaults, ability of managers to seek protection from creditors

=> Examination of Legal Rules of Pro-Investor vs. Pro-Management

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Empirical Question:

Do laws on investor protection differ across countries; And do these differences have consequences for company ownership?

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Cross Country Comparison

Study of 49 Countries of which:

• 18 belong to Common law

• 21 belong to French civil law

• 6 belong to German civil law

• 4 belong to Scandinavian civil law

Average measures of the sample countries in different legal families are taken for analyses.

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Shareholder RightsVoting procedures and rights attached to shares

“Antidirector rights” – an Index measure of how strongly the legal system favours minority shareholders against managers and/or dominant shareholders.

The index has value of 0 to 6 – one for each of the following rights to the (minority) shareholders:

1. Showing up in person to vote vs. sending proxy vote by mail

2. Blocking Shares - deposit shares in advance to shareholder meetings: restricts selling of stock=> may discourage shareholders from voting at all

3. Cumulative voting for directors and/or proportional representation on the board => more power to minority shareholders

4. Oppressed Minority - legal mechanisms against management oppression: courts and the right to repurchase shares

5. Preemptive right to buy new shares

6. Right to call extraordinary shareholder meetings – required % of holdings (<10%)

*Remedial measure: right to a mandatory dividend

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Mandatory Dividend Right – legal substitute for the weakness of other protections of minority shareholders

Few countries have legal rules protecting outside/minority investors

The origin of Law matters: Common Law countries have laws more protective of shareholders; Civil Law countries – less protective

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Do differences in scores by legal origin reflect differences in per capita income level?=> Countries sorted by GNP per capital level

Legal rules that are more protective of investors are NOT the reflection of higher per capita income.

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Creditor Rights

Protecting rights of some creditors (senior secured) with different interests have the effect of reducing the rights of other creditors (junior unsecured)!

We take the perspective of senior secured (collateralized) creditor

Creditor Rights are related to Liquidation & Reorganization:

1. No automatic stay on assets – does not prevent creditors to repossess collateral

2. The right to collateral – secured creditors are first in line

3. Reorganization with creditor consent – Chapter 11 in USA (pro management)

4. Management does not stay in Reorganization

* Remedial Creditor right: legal reserve requirement

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Creditor rights are more protected than shareholder rights, on average

Legal Origin Matters – Common law countries offer better protection to creditors (USA is an exception)

If liquidation is easy – less need to rely on reorganization => being soft on managers is not very relevant

Remedial rights = substitute for the weakness of other investor (unsecured) protections

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Conclusion:

• Common law countries protect investors/creditors the most

• French civil law countries protect investors/creditors the less

• German civil law countries are in the middle but close to other civil law countries (one exception is the protection of secured creditors)

• Country rankings according to shareholder AND creditor protections are the same and not that some legal families protect shareholders more while others protect creditors

• Poor investor protection is associated with difficulty in raising external capital. How do the French civil law countries compensate for their shortcomings?

=> Remedial rights: Mandatory Dividends & Reserve Requirements

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Law and Ownership

Hypothesis: Companies with poor investor protection have more concentrated ownership of shares:

• More need to avoid expropriation by managers => more need for control and monitoring

• When protection is poor small shareholders will only buy shares at discounted prices => not attractive for companies to issue new shares to the public => stimulates ownership concentration

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Legal origin Matters: French Civil law countries have the highest ownership concentration

The differences between French and other legal families are statistically significant

Ownership Concentration is substitute for poor legal protection of investors

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More on Corporate Ownership Around the World

Task: Comprehensive description of ownership patterns of large firms in rich countries.

Sample description:

• Two samples are taken from each of 27 countries: 20 largest publicly traded firms and 10 smallest firms (with close but not less that $500 million of market capitalization)

• Control of companies is based on 20% & 10% ownership of votes

• Divide countries into good (Antidirector Index=4,5) and bad (Antidirector Index=0,1,2,3) shareholder protection types and compare

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Types of Ownership

Widely held firms vs. firms with ultimate owners

Ultimate owner=Controlling Shareholder=Direct &Indirect voting rights>20 (10)%

Types of ultimate owners of sample firms:

1. Family or an Individual

2. State

3. Widely held financial institution (Bank or insurance company)

4. Widely held corporation

5. Miscellaneous (pension funds, mutual funds, other trusts & groups, non-profit organizations etc.)

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Types of Ownership

At 20% ownership - Widely HeldAt 10% - Family (Individual) Owned

At 10 & 20 % Family (individual) Owned

At 20% - Widely HeldAt 10% - Miscellaneous

(Group Owned)

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At 20% - Widely HeldAt 10% - Family Held through Direct + Indirect Votes

Owner – Widely Held Financial Institution (Bank) at 10 & 20 %

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Who Owns Firms?

Only 36% of the large publicly traded firms in the world are widely held

Among the companies with owners - Families and States dominate

Widely held companies are more common in good protection countries

All other types of ownerships are more common in low protection countries

Dispersion of ownership goes together with good shareholder protection, which enables controlling shareholder to divest at attractive prices

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10% cutoff - largest firms typically have ultimate owners, particularly in countries with poor shareholder protection.

Medium Sized firms ($500 mln) –widely held firms become more scarce making family controlled firms dominant ownership pattern in the world.

At 10 % cutoff –dispersed ownership becomes truly an exception (only 11%)

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Who Owns firms?

Summary: if we look at largest firms in the world and use a very tough definition of control, dispersed ownership is about as common as family control but if we move to medium sized firms and more lenient (but perfectly sufficient) definition of control of 10% ownership -widely held firms become an exception and family ownership a dominant pattern, especially in countries with poor investor protection.

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How Are Firms Owned?

Study of the mechanisms through which corporations are controlled by ultimate owners – reduce ownership below their control rights:

• Deviation from One share/One Vote principle - the fraction of book capital of ownership needed to control 20% of votes = measures superior voting rights

• Organize Pyramids – when the firm has an ultimate owner (as opposed to widely held) and there is another publicly traded company in the control chain of the owner and the firm=>disproportionate power relative to cash flow rights

• Cross Shareholdings – when the sample firm owns any share in its controlling shareholder – to reduce the threat to their control

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Barrick Gold has an ultimate owner AND the control is exercised through publicly traded company=Control through Pyramid (on 10% definition)

Toyota is controlled by Mitsui Group in which Toyota also has cross shareholdings

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How Are Firms owned?

The magnitude of deviation from one share-one vote is small – it takes to own 18.6% of capital to control 20% of votes

26% of companies with ultimate owners are controlled through pyramids – an important mechanism to separate Cash Flow ownership from Voting Rights

Cross shareholdings in controlling chain are rare

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How Are Firms Owned?

Ultimate family owners control 25% of the value of top 20 firms

69% of the families also participate in the management of the controlled firms – no separation of ownership and management occurs

Each family controls on average 1.33 firms

Significant ownership of equity by banks is rare (except Belgium and Germany – see details in the reading)

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Who Monitors the Families?

Do controlled firms have other large shareholder/owners (>10%) who would discipline each other from expropriation?

Large shareholders of all kinds are Alone in 75% of the cases

71% of the family controlled firms are the sole controllers of their firms 27

Summary

• Widely held firms appear to be relatively uncommon unless we look at specific countries

• Controlling shareholders often have control rights in excess of their cash flow rights, most commonly in the form of pyramids

• Family ownership and control turns out to be the dominant ownership type

• Controlling families participate in the management of the firms they own

• Banks do not appear to be significant equity (control) holders in firms

• Controlling shareholders are usually not monitored by other large shareholders

=>Family control of firms appears to be common, significant and unchallenged by other equity holders

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References:

* Porta, R., Lopez‐de‐Silanes, F., Shleifer, A., & Vishny, R.W. (1998). Law and Finance. Journal of Political Economy, 106(6), 1113-1155

* Porta, R., Lopez‐de‐Silanes, F., & Shleifer, A. (1999). Corporate ownership around the world. The journal of finance, 54(2), 471-517.

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Optional Readings/Presentations:

Anderson, R. C., & Reeb, D. M. (2003). Founding‐family ownership and firm performance: evidence from the S&P 500. The journal of finance, 58(3), 1301-1327.

Ang, J. S., Cole, R. A., & Lin, J. W. (2000). Agency costs and ownership structure. the Journal of Finance, 55(1), 81-106.

Cremers, M., & Ferrell, A. (2014). Thirty Years of Shareholder Rights and Firm Value. The Journal of Finance, 69(3), 1167-1196.

Doidge, C., Karolyi, G. A., Lins, K. V., Miller, D. P., & Stulz, R. M. (2009). Private benefits of control, ownership, and the cross‐listing decision. The Journal of Finance, 64(1), 425-466.

Dyck, A., & Zingales, L. (2004). Private benefits of control: An international comparison. The Journal of Finance, 59(2), 537-600.

Dyck, A., & Zingales, L. (2004). Control premiums and the effectiveness of corporate governance systems. Journal of Applied Corporate Finance, 16(2‐3), 51-72.

Edgerton, J. (2012). Agency problems in public firms: Evidence from corporate jets in leveraged buyouts. The Journal of Finance, 67(6), 2187-2213.

La Porta, R., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R. (2002). Investor protection and corporate valuation. Journal of finance, 1147-1170.

McLean, R. D., Zhang, T., & Zhao, M. (2012). Why does the law matter? Investor protection and its effects on investment, finance, and growth. The Journal of Finance, 67(1), 313-350.

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